IASB workplan developments
Yes, if finalized, it would change classification and/or presentation for existing financial instruments
No, we do not have financial instruments with characteristics of equity that would be impacted
Not sure yet
Exposure Draft: Financial instruments with characteristics of equity
EY Applying IFRS: The FICE project progresses
In November 2023, the IASB published the exposure draft Financial Instruments with Characteristics of Equity - proposed amendments to IAS 32 Financial Instruments: Presentation (ED).
The IASB is seeking to clarify IAS 32 and to provide more guidance for classifying and presenting financial instruments as financial liabilities or equity and, moreover, to resolve application issues companies encounter when applying the classification requirements in IAS 32.
A key objective of the amendments is to improve the information provided about the financial instruments issued by an issuing entity. The ED, therefore, also proposes to amend the objective of IFRS 7 to provide information on how the entity is financed, its capital resources, and its ownership structure, including potential dilution of the ownership structure from financial instruments issued at the reporting date.
The proposed amendments result in some significant additions to the existing IFRS 7 disclosure requirements and amend IAS 1 to require an entity to provide additional information about amounts attributable to ordinary shareholders.
The comment period for the ED closed on March 29, 2024 and well over 100 comment letters were submitted to the IASB.
Based on themes raised in the comment letters, there are currently areas in the ED which may be challenging to apply or could result in change in practice.
A selection of topics addressed by the ED, and certain considerations raised in comment letters, are summarized below – for a more detailed summary of the proposals of the ED, please refer to our comprehensive publication EY Applying IFRS FICE Project Progress, December 2023.
The Board proposed clarifications on what is to be considered in classifying a financial instrument (or its component parts) as equity or financial liability:
The ED proposes to clarify that only contractual rights and obligations that (i) are enforceable by laws or regulations; and, (ii) are in addition to those created by relevant laws or regulations; are considered in classifying a financial instrument or its component parts.
Such contractual rights and obligations must be considered in their entirety in classifying the financial instrument or its component parts.
Comments raised have emphasized however that the proposals may require significant judgement to apply and could result in unintended consequences. This could result in changes to classification and inconsistent outcomes for similar instruments.
Stakeholders are asking the IASB for clarification as to how the proposals would apply to principle-based regulation. For instance, in Canada, some instruments issued by banking institutions may have contractual terms that are added at the discretion of the issuer to comply with principle-based guidance published by the bank’s prudential regulator to obtain a specific capital treatment for those instruments.
In general, stakeholders have raised concerns that the proposals present challenges to application, possible significant changes in practice, new sources of diversity of application and, hence, could have a serious potential for unintended consequences.
The Board introduced proposed amendments and clarifications to the conditions for classification of a transaction settled in an entity’s own shares (commonly referred to as the “fixed-for-fixed” rules). The underlying principle of IAS 32 is that where an instrument can or is required to be settled in an entity’s own shares, such settlement can only be classified as equity where a fixed amount of shares is exchanged for a fixed amount of consideration.
The ED proposes to clarify that the amount of consideration exchanged for each of a company’s own shares is required to be in the company’s functional currency and either fixed, or varies solely because of a preservation or passage-of-time adjustment.
Furthermore, the ED proposes clarifications on contracts that give one party a choice of settlement between two or more classes of an entity’s own equity instruments.
Stakeholders shared their concerns that the proposal to require that the passage-of-time adjustments must fix the present value of the consideration on initial recognition, is overly restrictive. Furthermore, entities will need to apply judgment when assessing whether any change in compensation is proportional to the passage-of-time, and suggested that there are some aspects of this guidance which need further clarification and application guidance.
IAS 32 currently requires that an entity recognize a financial liability for an obligation to purchase an entity’s own shares, measured at the present value of the redemption amount. The ED proposes to clarify that such requirement also applies to contracts to purchase own shares by delivering a variable number of another class of own shares.
In addition, the ED clarifies that both the initial and subsequent measurement of such a liability should consider the earliest possible redemption date, ignoring the probability and estimated timing of the counterparty exercising their right to redeem. The ED also indicates that at each reporting date, as the value of the liability changes, due to the unwinding of the discount and changes to the forecast settlement amount, any such changes would be recognized in profit and loss.
Moreover, the ED proposes to clarify the requirements in IAS 32 that apply if a contract that includes an obligation for a company to purchase its own equity instruments expires without delivery.
Another clarification relates to written put options and forward purchase contracts on an entity’s own equity instruments that are gross physically settled. These instruments must be presented on a gross basis.
Entities that have written put options over non-controlling interests (NCI puts) will be affected by the ED's proposals related to obligations to purchase an entity's own equity instrument. Some stakeholders have criticized the proposals on the basis that they require the recognition of both NCI in equity as well as a put option liability. Although this is one of several different approaches applied in practice today for such written put options over NCI, many perceive this to be a form of double counting.
Stakeholders also have diverse views on the proposed measurement approach, which we have noted further in the following section discussing Contingent Settlement Provisions.
The IASB had identified that financial instruments with contingent settlement provisions, upon occurrence of an uncertain future event, have given rise to practice issues in applying IAS 32, including whether such instruments should be classified as a financial liability in their entirety, or as a compound instrument.
To address such practice issues, the ED clarifies that some financial instruments with contingent settlement provisions may be compound instruments comprising separate equity and liability components.
The ED also clarifies that, consistent with obligations to purchase an entity’s own equity instruments, the probability and estimated timing of occurrence (or non-occurrence) of an uncertain future event outside of the control of the entity, has no effect on the initial or subsequent measurement of the financial liability – the financial liability is to be measured on initial recognition and subsequently, at the present value of the redemption amount without regard to the probability of the contingent event occurring or not.
The ED also proposes that payments at the discretion of the issuer are recognized in equity, even if all the proceeds are initially allocated to the liability component of a compound financial instrument.
In addition, the ED clarifies the meaning of the terms “not genuine” and “liquidation”. Comments show that there are different views on the proposed measurement approach. Some see the benefits of the proposed approach in being consistent with the requirements of paragraph 23 of IAS 32 and, thus, avoiding what some might view as otherwise introducing significant changes to current requirements in IAS 32 and also avoiding adding complexity to the measurement calculation, as considering the probability of the contingent event occurring would involve significant judgement, continuous reassessment, and additional costs to preparers.
On the other hand, a significant number of comments point to a disagreement with introducing a new measurement approach for contingent settlement provisions and for obligations to redeem own equity instruments that ignore the impact of probability. This view argues that this is inconsistent with the key general measurement requirements of IFRS 9. Furthermore, they are concerned that the proposed measurement approach appears to exceed the objective of IAS 32, which is only to provide guidance on classification.
The ED provides examples of potential factors for an entity to consider when assessing whether a decision of a shareholder is treated as a decision of the entity, thereby supporting the classification of an instrument as equity.
Stakeholders are welcoming the introduction of additional factors to be considered when making the assessment as being helpful to entities. However, stakeholders are also suggesting the IASB consider providing additional application guidance and illustrative examples to help entities apply the proposed factors in the ED.
The ED proposes to clarify that financial liabilities and equity instruments cannot be reclassified after initial recognition, unless the substance of the contractual arrangement changes because of a change in circumstances external to the contractual arrangement — for example, a change in a company’s functional currency or a change in a company’s group structure.
The ED proposes that if an instrument is reclassified, it is applied prospectively from the date the change in circumstances occurs.
Stakeholders are welcoming the introduction of guidance for the reclassification of financial liability and equity instruments, however commenters emphasize that it would be preferable for the reclassification requirements to give greater priority to representing the contractual substance of financial instruments at each reporting date. For instance, if a feature of a compound instrument, classified as a liability, expires due to the passage of time, leaving only equity-related features, the proposed amendment might not permit reclassification to equity under unchanged external circumstances.
The ED aims to enhance the disclosure of financial instruments issued by the entity. The proposed changes to IFRS 7 seek to provide information on the entity's financing, capital resources, and ownership structure, including potential dilution of ownership from financial instruments issued at the reporting date.
Stakeholders have raised concerns that these disclosure proposals will significantly increase an issuer's disclosure obligations.
Stakeholders are also seeking clarification on how liquidation priority disclosures would apply to entities operating in multiple jurisdictions with differing liquidation rules. Some are also requesting guidance on aggregating disclosures.
Moreover, stakeholders highlight a potential overlap within these disclosure requirements with other reporting and disclosure requirements within and outside the financial statements. Overall, given significant feedback on the Exposure Draft, stakeholders with an interest in the FICE project should continue to follow the IASB’s project to understand the Board’s next steps.
Power purchase agreements
The use of Power Purchase Agreements (“PPA”) is increasing as corporate offtakers respond to continued stakeholder scrutiny on emissions and pressure to transform power consumption to renewable power. This increased demand for PPAs is expected to escalate in line with companies’ commitments to becoming carbon free. The characteristics of PPAs, and related features of renewable energy, have resulted in entities experiencing application challenges and questions when applying the requirements in IFRS 9 Financial Instruments.
PPAs can be broadly grouped into physical PPAs and virtual PPAs. Under a physical PPA, the purchaser has a contractual obligation to gross settle the volume of electricity delivered under the contract. A virtual PPA is a contract for the settlement of the difference between the spot price and the contractually specified price without any obligation to take delivery of energy. A virtual PPA’s cash flows fluctuate based on market price of electricity and is in substance a derivative and thus accounted for as such under IFRS 9.
For physical PPAs, although there is physical delivery of energy, financial statement preparers need to be aware that contracts to buy or sell a non-financial item can still be considered a financial instrument under IFRS 9, if the contract is capable of being net settled in cash or another financial instrument. IFRS 9 provides examples of when an executory contract may be net settled – of particular relevance for physical PPAs, a contract may be net settled if the underlying is readily convertible to cash. In instances where the underlying is a commodity (like electricity), an entity needs to consider all facts and circumstances and apply judgement in their assessment of whether the underlying is readily convertible to cash.
Based on current interpretation, electricity is generally considered to be readily convertible to cash, but the outcome may depend on the location of the production site and whether it is connected to the local grid. Entities may need to exercise judgement when assessing whether electricity is readily convertible to cash based on the terms of the PPA and the local environment. IFRS 9 does provide an exception to having to account for a contract to buy or sell non-financial items which can be settled net as financial instruments, if it is held in accordance with the entity’s expected purchase or usage requirements, also referred to as the “own-use exemption”. However, there are specific challenges that arise when applying the “own-use exemption” for physical PPAs, when the purchaser cannot store the excess electricity and it has to either be consumed or sold within a short time, which is a common problem for renewable energy contracts, where the generation of electricity via natural sources may not match timing of consumption needs. As an example, a PPA may require a purchaser to purchase a fixed share of wind energy produced at all times of generation, however the purchaser’s electricity needs may only be during working business hours, leading to a mismatch between the demand profile of the purchaser and the supply profile of the renewable energy generator, and raises questions as to whether the PPA is held by the purchaser to satisfy it’s “expected purchase or usage requirements”.
In order to address some of the specific challenges which were highlighted by a submission about applying the ‘own-use’ exception in IFRS 9 to physical delivery contracts to purchase energy, the IFRS Interpretations Committee (IFRIC) recommended in June 2023 that the International Accounting Standards Board (IASB) undertake a narrow-scope standard setting project, as “the principles and requirements in IFRS 9 do not provide an adequate basis for an entity to determine the required accounting for some PPAs in a consistent way”. In July 2023, the IASB added a project to its work plan to research whether narrow-scope amendments to IFRS 9 could be made to better reflect how financial statements are affected by PPAs. Subsequently, the IASB tentatively decided to further explore narrow-scope standard setting.
The IASB first discussed the issue in December 2023 and further discussed potential narrow-scope amendments regarding the requirements in IFRS 9 with respect to the ‘own-use’ and hedge accounting requirements at a meeting in March 2024. Following this, an Exposure Draft entitled Contracts for Renewable Electricity was issued in May 2024, with the stated primary objective of ensuring that financial statements more faithfully reflect the effects that renewable electricity contracts have on a company. The Exposure Draft includes proposed amendments to IFRS 9, as well as IFRS 7 Financial Instruments: Disclosures. Entities should take note of the proposed amendments as the prevalence of physical and virtual renewable energy PPAs continues to grow.
The scope of the proposed amendments is for contracts for renewable electricity with both of the following characteristics:
the source for production of the renewable electricity is nature-dependent such that supply cannot be guaranteed at specified times or for specified volumes. Examples are wind, solar and hydroelectricity
the purchaser is exposed to substantially all of the volume risk (the risk that the electricity produced does not align with demand at that time) through “pay-as-produced” features.
As discussed above, under the current guidance entities may be challenged in assessing whether the ‘own-use exemption’ is met based on the terms of the PPA and the local environment, which can be quite judgmental and may result in diversity in practice. The IASB has therefore proposed the following amendments to help clarify the ‘own use’ assessment. For contracts for renewable electricity, from the contract’s inception and throughout its duration, the purchaser will consider:
the purpose, design and structure of the contract, including the volumes of electricity expected to be delivered over the remaining duration of the contract and how they continue to be in accordance with the entity’s expected purchase or usage requirements (the entity is not required to make a detailed estimate for periods far in the future – reasonable and supportable extrapolation may be allowed); and
the reasons for past and expected sales of unused renewable electricity within a short period after delivery, and whether such sales are consistent with the entity’s expected purchase or usage requirements. A sale of unused renewable electricity is in accordance with the entity’s expected purchase or usage requirements only if all the following criteria are met:
the sale arises from the entity’s exposure to the volume risk, giving rise to mismatches between the renewable electricity delivered and the entity’s electricity demand at the time of delivery;
the design and operation of the market in which the electricity is sold results in the entity not having the practical ability to determine the timing or price of the sale; and
the entity expects to purchase at least an equivalent volume of electricity within a reasonable time (for example, one month) after the sale.
Under the current guidance, the general challenge for achieving hedge accounting for contracts for renewable electricity (that would be within the scope of the amendment) arise from the fact that, unlike most other forecast transactions where cash flow variability only arises because of price uncertainty, in a contract for renewable electricity cash flow variability arises because of both price and volume uncertainty. More specifically, for the seller, given the uncertainty about the exact volume of electricity that would be produced, there are challenges with describing the highly probable forecasted sales with sufficient specificity. For the purchaser, the hedged item can be designated as the purchaser’s expected electricity needs, however challenges arise when assessing the effectiveness of the hedging relationship given variable volume of the hedging instrument relative to fixed volume of designated hedged item.
The IASB has therefore proposed that for cash-flow hedging relationships in which an in-scope contract is designated as a hedging instrument, an entity is permitted to designate a variable nominal volume of forecast electricity transactions (either sales or purchases) as the hedged item if all of the following apply:
the hedged item is specified as the variable volume of electricity to which the hedging instrument relates:
the variable volume designated does not exceed the volume of future electricity transactions that are highly probable, except forecast sales are not required to be highly probable if the hedging instrument relates to a proportion of the total future renewable electricity sales from the production facility; and
the hedged item is measured using the same volume assumptions used for the hedging instrument.
The Exposure Draft proposes that an entity that is a party to contracts for renewable electricity that meet the scoping characteristics must disclose information about how these contracts affect the amount, timing and uncertainty of the entity’s future cash flows (regardless of whether the own-use or hedging amendments are applied). There are also specific disclosure requirements for sellers and purchasers that show how the contracts affected their financial performance for the reporting period.
For the proposed amendments to the own-use exception, an entity is not required to restate prior periods (it is only permitted to do so if it can be done without using hindsight). Otherwise, it must recognise any difference between the previous carrying amount, and the carrying amount at the beginning of the reporting period in which the amendments are first applied, in opening retained earnings of that reporting period.
The proposed hedge accounting amendments must be applied prospectively to new hedging relationships designated on or after the date the amendments are first applied. In addition, an entity is permitted to change the designation of the hedged item in a cash flow hedging relationship that was designated before the date the amendments are first applied without discontinuing the hedging relationship.
The IASB will consider all comments on the Exposure Draft received in writing by August 7, 2024. The IASB aims to finalise any changes by the end of 2024, with the proposal that the new requirements will be available for companies to apply as soon as possible after they are finalised. For further information please refer to EY’s global IFRS Developments publication.
